December 2, 2018 R Star

Risk/Reward Vol. 400

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

All three major indices experienced a huge rebound this week, jumping 5% on average and going positive again for the year. The impetus was a comment by Fed Chair Jerome Powell on Wednesday that interest rates were "just below" the Fed's estimate of "neutral". The neutral rate (also called the natural rate, r-star or r*) is the short term interest rate that prevails when the economy is at full employment and inflation is stable. In other words it is the rate that neither accommodates nor restricts economic growth. As loyal readers of this publication know, the Fed has maintained "accommodative" rates for more than a decade. Powell's comment was interpreted to be a walk-back from his statement in October that these very same rates were "a long way" from the neutral one. Mr. Market, for one, believed it to be. Although the smart money still believes a rate increase is a certainty in December, it now pegs the probability of two rate increases in 2019 at only 29%. Before Powell's comment this week, many had speculated there would be three increases in 2019. .

So why did Powell's comment cause the bulls to run? Lower Fed funds rates translate into cheaper short term money for corporations all of which rely on this type of financing for working capital. Cheaper working capital lowers cost which in turn raises profits. Higher profits mean higher stock prices. No wonder Mr. Market leaped for joy. Also, lower rates make bonds less attractive thus causing investment flows into equities. So does Powell's comment really signal a change in Fed policy? Some wags cautioned not, but their views went unheeded. The proof will be found in the "dot plot" issued after the Fed's upcoming December meeting. It tracks where each Fed member sees rates headed over the next several months.

Also adding to the uptick in stocks this week was the prospect of Presidents Trump and Xi resolving the Sino-American trade war that is brewing. I wrote this edition before any news on this front was forthcoming. Keep your eyes and ears peeled.